UK FSA Publishes Turner Report on Bank Regulation

The UK Financial Services Authority has announced that it has published:

Lord Turner’s Review and the supporting FSA Discussion Paper. These take an in-depth look at the causes of the financial crisis and recommend steps that the international community needs to take to enhance regulatory standards, supervisory approaches and international cooperation and coordination.

The Turner Review, as the report is called, starts with a very good review of ‘How did we get here from there?’, with a particular emphasis, of course, on the UK situation. For those interested in the US MMF initiatives, there is the comment:

The development of mutual-fund based maturity transformation was much less important in the UK than in the US: UK consumers do not to a significant extent hold mutual-fund investments as bank deposit substitutes. And while several UK banks set up SIVs and conduits, the scale was in general smaller than those of the big US banks. But US mutual funds and SIVs were very significant buyers of UK securitised credit: when they stopped buying, a large source of funding for UK credit extension disappeared.

There’s an attack on market efficiency … which is explicitly used as an argument for more wise and beneficial official influence of market prices:

  • Market efficiency does not imply market rationality.
  • Individual rationality does not ensure collective rationality.
  • Individual behaviour is not entirely rational.
  • Allocative efficiency benefits have limits.
  • Empirical evidence illustrates large scale herd effects and market overshoots.

There has been a recent, media-fueled resurgence of interest in financial models and their role in the crisis; the report contains a section on “Misplaced reliance on sophisticated maths”:

Four categories of problem can be distinguished:
  • Short observation periods…
  • Non-normal distributions…
  • Systemic versus idiosyncratic risk….
  • Non-independence of future events; distinguishing risk and uncertainty….

I suggest that these problems are not root causes, but symptoms. Believe me, the people who understood the models knew their limits very well. But in any large business, facts are used in the way the famous drunk uses a lamp-post: for support rather than illumination.

I have previously reviewed the problems inherent in estimating Loan Default Correlation. I suggest that the root cause of the problems in this process is the bigness of banks; there are too many layers of management eagerly telling their superiors what they want to hear, rather than making a Career Limiting Move and playing Cassandra. It is for this reason that there should be a surcharge on Risk Weighted Assets for size.

In fact, however, Lord Turner makes an almost sacreligious attack on market discipline – the Third Pillar of Basel II that I have attempted to defend from OSFI’s depredations. Lord Turner claims:

A reasonable conclusion is that market discipline expressed via market prices cannot be expected to play a major role in constraining bank risk taking, and that the primary constraint needs to come from regulation and supervision.

I suggest a more reasonable thing to try is disclosure … not disclosure from the banks, which is currently ignored, but disclosure by portfolio managers. Anybody with a licence to make discretionary trades for clients should be publishing returns – full and complete returns, which should then be published by the regulators (with spot checks for verification, same as with everything else that gets filed). In this way, we can hope to decrease the influence of salesmen in the industry; portfolio management is largely regarded primarily as an unfortunate regulatory cost to be minimized.

For purposes of this review, I’ve only skimmed over the first section. However, there is a section (2.9) of the more meaty sections of the report that brought tears of joy to my eyes:

Several commentators have argued for a clear separation of roles in which:
• Banks which perform classic retail and commercial banking functions, and which enjoy the benefits of retail deposit insurance and access to lender of last resort facilities, would be severely restricted in their ability to conduct risky trading activities.
• Financial institutions which are significantly involved in risky trading activities would be clearly excluded from access to retail deposit insurance and from [Lender of Last Resort] facilities, and would therefore face the market discipline of going bankrupt if they ran into difficulties.
The theoretical clarity of this argument has attracted considerable support.

The key tools to achieve [elimination of Too Big To Fail status] will include:
• A regulatory regime for trading book capital (discussed in Sections 2.2 (ii) and (vi)) that combines significantly increased capital requirements with a gross leverage ratio rule which constrains total balance sheet size. Such a regime could include very major variation in capital requirements as between different types of trading activity, effectively achieving a distinction between market making to support customer service and proprietary position taking. The fundamental review of the trading book capital regime, proposed in Section 2.2 (ii), should consider the potential to achieve such distinction.

4 Responses to “UK FSA Publishes Turner Report on Bank Regulation”

  1. […] from Investment Banking (the “utility banking” and “casino banking” of the Turner Review) and should not be housed under the same roof – and this from one of the conglomerators: what he […]

  2. […] increase the bank’s liquidity requirements, in accordance with the Turner Review (previously discussed on PrefBlog): Similarly, if banks have to hold more assets in liquid form, and more of those in super-liquid […]

  3. […] Turner Report on Financial Regulation was reported on PrefBlog in March. The government has now taken some time off from its regularly […]

  4. […] Adair Turner, of Turner Report fame, has some things to say about bank regulation: “If we were philosopher kings designing a banking […]

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